The Biggest Obstacle

Ending the current recession requires solutions to three distinct-but-interconnected crises: 1) a housing crisis tied to the bursting of a speculative bubble; 2) a financial crisis tied to the collapse of the unregulated “shadow” financial system; and 3) an aggregate demand crisis caused by reductions in consumer and businesses spending due to the consequences of #1 and #2 and the self-reinforcing nature of demand crises.

Since taking office, the Obama Administration has moved address the housing and demand crises, but, like the Bush administration, it has struggled to manage the financial one. Yet no progress will be made in either ending the recession or advancing other elements of a progressive policy agenda unless the financial crisis is resolved.

In a blog post, former U.S. Secretary of Labor Robert Reich lays out the stakes:

The Wall Street bailout is starting to look like the most expensive tax-supported fiasco in history. The problem for the Obama administration is that this bailout is near the very center of the President’s economic recovery program. It’s not possible for the economy to bounce back until credit markets are working again. Yet even though the bailout so far is a bust, [Treasury Secretary Timothy] Geithner still hasn’t decided — or told the public — how he’s going to use the remaining $300 billion of bailout money differently.

The President cannot afford to lose the public’s confidence that his administration is a careful steward of the public’s money. The public was willing to go along with a large stimulus package. But it won’t go along with a second stimulus, and certainly not another TARP. And until the public feels confident that its money isn’t being thrown down a rat hole, it may balk at other ambitious undertakings such as health care or education or the environment.

Bottom line: Before it can clean up Wall Street or do much of anything else, the Administration has to clean up the way it’s been trying to clean up Wall Street.

Reich’s clean up, however, will not occur unless the administration recognizes that the solution fundamentally is a political, not technical, one. Progress will not happen unless the administration and Congress agree to challenge directly the power of the nation’s large, influential but disgraced financial institutions — a challenge that Washington so far had avoided, at least until this week’s scandal about the behavior of American International Group (AIG).

Economics blogger James Kwak describes the the political challenge and opportunity presented by the AIG scandal:

However, this scandal may yet serve a purpose. One characteristic of both administrations’ responses to the crisis has been to devise subsidies for the financial sector that are too complicated for even conscientious readers to make out, such as the asset guarantees for Citigroup and Bank of America, or the preferred-to-common conversion for Citigroup. Employee bonuses, by contrast, are strikingly easy to understand.

The key issues throughout this crisis have been political as much as economic. In this case, the Obama administration has been taking a difficult political position – propping up financial institutions in their current form and insisting everything will be OK – when it would have been easier to play the populist card. This was by no means an inescapable choice; according to news reports in February, David Axelrod and Rahm Emmanuel were in favor of being tougher on the banks. Perhaps the AIG bonus scandal will force the administration’s hand toward the decisive action that we need.